Federal Budget: Property policy changes that leave everyone wanting more

At a very high level, the property measures in this year’s budget tread a middle of the road path that ultimately satisfy few market participants. Property investors are unhappy, as taxation incentives are wound back, but the grandfathering of negative gearing means little risk of sales altogether. Despite talk of intergenerational equity, the modest boost to the supply of new homes is unlikely to move the needle on affordability, with a slightly softer path for home values driven by reduced property demand (due to the less attractive policy settings for new investors)unlikely to give first home buyers a huge boost.

A more detailed look

When compared with other years, the property sector is notably at the forefront of this year's budget, with a range of measures across tax policy and public investment/supply provision that will create different outcomes for owner-occupiers, investors and builders (when compared with the existing policies in place).

From the taxation side, the key measures (flagged well in advance) were changes to the existing arrangements to the capital gains tax discount (CGTD) and negative gearing, two policies that have provided investors with taxation benefits over recent decades.

On capital gains tax, taxation will transition from the existing 50% discount on nominal realised gains to an indexed approach (with tax applied to the real gain over the holding period), which was the system in place prior to September 1999. The change takes effect from 1 July 2027. Capital gains are split at that date, with gains accrued up to 1 July 2027 eligible for the 50% discount, and gains accruing after that date taxed under the indexation approach. Investors in new builds can choose either the discount or the indexation approach when they sell their property. Interestingly this also draws in assets previously untaxed - assets purchased prior to 1985 (when capital gains tax was first introduced) were not subject to any CGT, however properties will now be taxed on gains accrued after 1 July 2027.

In addition, a minimum tax rate of 30% will be applied to capital gains, with the same minimum rate applied to discretionary trusts. The first part may reduce the incentive to hold on to investment properties past retirement, as capital gains were previously treated as income for tax purposes, and therefore previously sales made post-retirement would reduce the tax paid on these gains due to lower income.

On negative gearing, investors holding property at budget night will be grandfathered, retaining the ability to offset rental losses against taxable income. Investors purchasing established properties after budget night will have a grace period, with the ability to negatively gear until 30 June 2027. After that, full negative gearing will be limited to new builds, with losses on established properties quarantined to rental income.

On public investment/supply provision side, there was around $2 billion of additional funding announced for enabling infrastructure, supporting connections of essential services (water, sewage, electricity etc) along with local roads. This funding is contingent on reforms at the state and local government levels to speed up planning and approvals along with the supply of land for development.

Other supply side measures include streamlining access to the National Construction Code, which will lower costs, improve transparency and could lead to productivity improvements in construction, and fast-tracking skills recognition for migrants.

What does this mean for the property sector? As with most government policy changes, it will depend on how market participants respond to new incentives. In the lead up to these changes, there was commentary that changes to the CGTD and negative gearing would drive investors to sell properties altogether and reduce the rental stock (leading to a rapid increase in rents). We would argue that this scenario is quite unlikely for the following reasons:

The grandfathering of negative gearing for existing investors reduces the motivation to sell in the short term – in fact these changes could see existing investors motivated to hold their properties for longer, rather than giving up their tax benefits. Given that rental yields are so low for Australian housing (gross rental yields average just 3.4% across Australia’s capitals, well below the cost of finance), a large proportion of recent investors likely operate on a negative cashflow basis. As they will not face additional pressures on cashflows related to any shortfall in rent payments versus costs, it’s unlikely we will see a sudden or sharp rise in investor-owned properties coming to market.

Similarly, changes to capital gains tax seem unlikely to drive mass selling, as the negative impact of such a move on home values (and therefore the realised gain in the short term) would likely result in a lower post-tax return than would be the case of holding the property for longer to generate a large gain. Arguably, investors with a long tenure may be less inclined to sell, while investors more recent to the market could be more motivated to sell their home before capital gains tax rules revert.

However, these changes are likely to discourage new property investors from purchasing existing stock, particularly as the negative cashflow, due to low yields and high holding costs, becomes much less attractive without the compensation of negative gearing. This substantially increases the carrying costs of property investment.

Currently investment in new housing is a relatively small share of the total, but the relative advantages (negative gearing, the 50% CGT discount, the potential for stamp duty discounts and greater depreciation benefits) may encourage an increase in investment activity here but there may be other factors (such as location of new construction for example) that may discourage investment. The likely net effect of these policy changes is an overall reduction in property investment. This appears to the be the expectation underpinning Treasury's modelling, which suggest weaker housing demand (from a decline in investor activity) resulting in house price growth being around 2% lower than the case under existing policy settings "over a couple of years" (note: this was Treasury's wording). However, there is an expectation of growth in owner-occupier housing as a result of this change.

One factor that has not been widely covered is the risk of a hollowing out of rental stock in the inner and middle ring suburbs of Australian cities. These rental properties will only be grandfathered for the current investor, and negative gearing would not be permitted once these properties are sold, making them less likely to be available for rent. Instead it would likely drive investment demand/rental supply to greenfield developments on the fringes, or new unit developments.

Supply side measures such as the funding for enabling infrastructure, along with the carrot of tying this funding to pro-housing policies at the state and local government levels are positive, but are ultimately indirect policies. They rely on the support of other levels of government and ultimately on private sector firms to complete construction projects. Treasury clearly believe that these measures will provide a boost to the feasibility of projects, reducing the costs of new construction, but it's not clear that it will be enough to get over the hurdle of raw materials costs (particularly given the latest cost pressures related to the conflict in the Middle East) and labour availability. This is particularly the case in a market like Melbourne, where limited home value growth over the past five years has stretched the feasibility of new construction projects, relative to cities that have seen rapid growth, such as Perth or Brisbane.

On a net basis, the combined policy measures imply a modest uplift in housing supply over the decade. Enabling infrastructure is expected to support up to 65,000 additional homes, while Treasury modelling suggests around 35,000 fewer homes due to weaker investment, implying a net increase on the order of 30,000 dwellings. While this is overall a positive, these are somewhat marginal gains, when you consider the goal of the National Housing Accord of 1.2 million homes constructed over a 5 year period.

Treasury's modelling suggests a modest upwards impact on rents as a result of the combined CGT/negative gearing change. The impact of these measures is forecast to lead to an increase in rents of around $2/week.

There may be some intangible benefits to the broader economy from this change. There have long been concerns around Australia's poor productivity growth, with some observers suggesting the generous tax benefits afforded to non-productive property investment has contributed to this trend. A rebalancing in Australian investment portfolios may encourage more risk-taking investment that could boost longer term productivity growth.